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Safety Becomes Stigma as Leveraged Loans Cut Out Covenants

(Bloomberg) -- Protections have gotten so lax in the $1 trillion market for U.S. leveraged loans that if an offering comes with decent covenants, lenders take it as a sign that something’s wrong with the deal.

“You do have to think twice when you see a loan with a covenant these days,” says Thomas Majewski, managing partner and founder of Eagle Point Credit Management.

It’s not a crazy assumption in a market where 75 percent of new loans are now defined as “covenant-lite,” meaning a company could, for example, rack up as much debt as it wants regardless of its performance. In such a lenient atmosphere, the reasoning goes, a loan must be a stinker if a borrower has to resort to promising even standard protections.

“It’s basically the worst it’s ever been in terms of loan covenant protections,” says Derek Gluckman, senior covenant officer at credit-rating firm Moody’s Investors Service. And that includes the heady pre-crisis year of 2007. A covenant-lite loan refers to debt where the issuer doesn’t have to meet periodic performance goals, known in the trade as maintenance covenants.

It might make sense to cut some slack for bigger, more stable companies, but investors are raising the alarm on loans to middle-market borrowers with Ebitda under $50 million that have less room to bounce back from a mistake. Many small companies are unproven, first-time issuers, and the risks are even greater if their business is cyclical.

At the same time, lenders are giving up compensation for the risk they’re taking by accepting skimpy yields and turning a blind eye to accounting maneuvers that downplay leverage.

Take SnapAV, which sells its own brand of audio-visual equipment to businesses that in turn install them in people’s homes.

Private equity firm Hellman & Friedman raised $265 million in covenant-lite loans last month to fund its acquisition of the Charlotte-based business. Investors agreed to forgo the protections even as the new owner used an accounting method known as add-backs to reduce a measure of the company’s leverage, which makes it look more creditworthy. The add-backs, which take into account things like deferred revenues, boosted Ebitda by about a third to $50.1 million from $37.5 million. That reduced its leverage to 5.4 times from more than seven times, according to loan documents sent to investors.

The adjustments have become so prevalent that Ian Walker, an analyst at Covenant Review, says he can’t remember a private equity-backed deal done without them. Walker estimates 85 percent of loan deals for bigger companies backed by large private equity firms are now considered covenant-lite.

Junk-bond pioneer Michael Milken said this month the ability to do these types of deals was contributing to a “golden age” for private equity firms. “You can leverage, you can borrow without covenants, and so for equity holders it affords you very unusual rates of return,” Milken said in an interview with Bloomberg Television in Singapore.

It was “one of the smallest covenant-lite issuances to date,” Jason Van Dussen, Golub’s head of capital markets, said at the time. That means the 20-odd lenders who bought the deal effectively will have no bargaining power if Rough Country ever drives off a financial cliff.

Representatives for Hellman & Friedman and Golub declined to comment. A representative for Gridiron didn’t respond to requests for comment.

Just because a loan is light on covenants, that doesn’t necessarily mean it’s always going to be riskier, according to Bank of America Corp. analysts led by Neha Khoda.

“Cov-lite issuers tend to be bigger and better capital structures, perhaps the reason why they were able to attract enough investor demand in the first place, despite having no maintenance covenants,” the analysts wrote in a report this week. Leveraged loans have returned just above 2 percent this year, according to index data.

But if the company gets into trouble, holders of term loans may find they’re at a disadvantage to lenders who extended other types of debt and did insist on covenants, such as banks that provided revolving credit lines. A broken covenant could entitle the latter to extract concessions, but term lenders wouldn’t have that negotiating lever, says Covenant Review’s Walker.

The risks are magnified for middle-market companies because term loans typically are held by fewer investors. Any potential losses would be shared among a smaller group, and selling out the holding is much harder.

“If you agree to this, you’re handing over control of your destiny,” Walker says.